Market Brief: Israeli Strike Triggers Short-Lived Volatility Spike

CalendarApril 19, 2024

Foreign exchange markets are slowly reverting to normal after suffering a major selloff last night when Israel launched strikes against targets near the Iranian city of Isfahan - home to facilities associated with the country’s nuclear program, including its underground Natanz enrichment site. Risk-sensitive currencies plunged amid a wholesale flight to safety as initial reports flooded in, but reaction began to fade as officials in both countries downplayed the action, portraying it as a limited retaliatory strike aimed at avoiding an escalatory cycle that could push the Middle East closer toward war. Iranian state media claimed air defence systems had shot down several flying objects with no damage to military or nuclear facilities, and authorities lifted flight restrictions and opened airspace over the country.

The Mexican peso remains badly shaken after enduring one of the worst intraday sell-offs in years. The exchange rate fell more than 6 percent in less than 15 minutes amid thin trading conditions, and remains almost 1.5 percent lower as we go to print, suggesting that speculators received a rude reminder of the dangers associated with “carry trading” - borrowing in low-yielding currencies and investing in high-yielders. Enormous rate differentials should keep the “superpeso” well-supported, but with background volatility continuing to rise, demand for carry trades looks set to fade in the months ahead, potentially reducing the currency’s outperformance relative to the greenback.

After surging above the $90 mark, global benchmark crude prices look likely to track lower through the day as geopolitical risk fades and fundamental supply and demand dynamics reassert themselves. With oil exports playing a significant role in propping up the governing regime, Iran is believed unlikely to seek further escalation against Israel and its allies, while the hawks in Tel Aviv should find themselves restrained by the United States - and the grim strategic calculus associated with opening another front in the conflict. Global inventory balances appear consistent with a well-supplied market, and OPEC’s excess capacity is rivalling levels seen during the pandemic as voluntary cuts keep potential output off the market.

The dollar is giving back some of last night’s gains, but remains elevated after John Williams - long considered one of the most influential members of the Federal Reserve’s rate-setting committee - said “I definitely don’t feel urgency to cut interest rates,” and warned that while more tightening was not his “baseline” expectation, further hikes could not be ruled out if inflation failed to cool. The two-year Treasury yield is flirting with the 5-percent threshold, and the ten-year is holding just below 4.6 percent as easing expectations fade. The euro is down 1.3 percent, the Canadian dollar and pound are both trading roughly 1.5 percent lower on a month-to-date basis, and the Japanese yen’s losses are closer to 2.1 percent.

The dollar’s strength is drawing comparisons to the conditions that prevailed ahead of the 1985 Plaza Accord, in which the United States worked with its allies to drive the greenback lower. After meeting on the sidelines of the International Monetary Fund spring conference in Washington earlier this week, finance officials appeared to lay the foundation for a coordinated intervention effort, with Treasury Secretary Janet Yellen, Japanese Finance Minister Shunichi Suzuki and South Korean Finance Minister Choi Sang-mok issuing a statement pledging to “consult closely on foreign exchange market developments in line with our existing G20 commitments, while acknowledging serious concerns of Japan and the Republic of Korea about the recent sharp depreciation of the Japanese yen and the Korean won.”

We don’t think a repeat is likely. At other historical junctures, the Biden administration might have valued the export-flattering effects of a depreciating dollar enough to support a US-led intervention effort, but in today’s inflation-inflected election cycle, the political risks are likely too great. Instead, American officials seem content to give Japanese and Korean officials the political cover necessary to work in concert with one another against further exchange rate depreciation.

Next week will get off to a relatively slow start, but should then pick up speed. Tuesday will bring the first round of April purchasing manager indices, helping to confirm whether last month’s apparent rebound in the global manufacturing cycle can be sustained. The US will deliver March durable goods orders in parallel with Canada’s February retail sales numbers on Wednesday. But things will heat up on Thursday with the US first-quarter gross domestic product and Canadian employment numbers, and come to a head with Friday’s personal income and consumption report. Markets are positioned for a modest cooling in the US economic growth rate and in the core personal consumption expenditures index, but with strong labour markets supporting incomes and consumption, investors are acutely aware that risks are biased to the upside.


Karl Schamotta

Karl Schamotta

Chief Market Strategist

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